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Gift Giving Strategies for 2011 and 2012

Tax legislation passed in December 2010 included an unexpected estate planning bonus--a lifetime gift, estate, and GST tax exemption of $5,000,000 per person. Unfortunately this increased exemption applies only for 2011 and 2012, creating a short window of opportunity for high net worth clients to reduce their estates through lifetime gifts.

The changes in the lifetime gift tax exemption didn't change the basic gifting rules, nor did they change the rules relating to the annual gifts that can be made totally free of tax.

The annual gift tax exclusion is still in effect:

An individual can make a gift to another individual (other than a spouse) of up to $13,000 during 2011 (this amount may be adjusted in 2012 for COLA increase)

Gifts to spouses are unlimited (except for non-U.S. citizen spouses, where the limit is $134,000 for 2011)

A married couple can make joint gifts of up to $26,000 but must file a gift tax return if the gift is made from one spouse's assets and the other spouse consents to apply his/her exemption to the gift (this is called "gift splitting")

Gifts under the annual exclusion threshold are free from any federal gift tax consequences

Direct payments to colleges or hospitals for the benefit of another person do not count against the annual exclusion

The lifetime gift tax exemption has been modified:

The amount that can be given away is $5,000,000 for 2011 and 2012 ($10,000,000 for a married couple), in lieu of the $1,000,000 gift tax exemption that has been in effect since 2002

The GST (generation skipping tax) limit has also been increased to $5,000,000 for 2011 and 2012, allowing for larger gifts to future generations

Gift Tax ReturnA gift tax return needs to be filed only in years when taxable gifts are made. Gifts less than $13,000 per individual do not need to be reported. (However, if a couple makes a gift of up to $26,000 but splits the gift between the spouses, then a return does need to be filed so the spouse that did not own the assets can elect to use his/her exclusion.) All gifts over these amounts are recorded on the gift tax return. Over many years of gifting, the returns bring forward the cumulative taxable gifts that have been made. It is important to understand that, although they are called taxable gifts, there is no actual tax due as long as the lifetime gift tax exemption hasn't been exceeded.

The lifetime gift tax exclusion is a "unified" amount, meaning that you can use the $5,000,000 either for gift taxes or estate taxes, but not both. When the client passes away, the final gift tax return indicates the amount of the exclusion already used for lifetime giving, and only the excess can be used to pay estate taxes. For example, if John has a $7,000,000 estate and decides to make a gift of property worth $5,000,000 to his four children, the amount of the taxable gift will be $4,948,000 (the excess over four annual gift exclusion amounts of $13,000, or $52,000 total). When he dies several years later, only $52,000 of the exemption is available to offset the value of the remaining assets in his estate, with the excess subject to estate taxes.

You can make gifts of all types of property, including cash, securities, real estate, businesses, jewelry, and other personal property. You need a qualified appraisal for everything other than cash and publicly traded securities. And remember that the tax basis for the property carries over from the donor to the donee and is not stepped up to fair market value at the time of the gift.

Planning Opportunities for High Net Worth ClientsIn order to benefit fully from the increased exemption, clients need a high net worth, as well as assets that will appreciate in value. It goes without saying that before making irrevocable gifts of this magnitude, clients need to understand the economics of the transaction and be assured that it doesn't reduce their net worth to an unacceptable level.

Most clients hesitate to make large outright gifts to their children and heirs, so you need to be familiar with sophisticated strategies to transfer assets. Most people want assurances that the funds will be available for several generations and protected from creditors or predators. With the GST exemption at $5,000,000, these multi-generational transfers are finally a possibility.

Some techniques to consider are:

Family limited liability company (FLLC)This is a technique that has been around for a long time and still is a viable alternative, especially for clients who want to retain some measure of control. It works well with rental real estate and other business assets. If the clients transfer minority interests in the FLLC to their heirs, they can "leverage" the amount of the gift by taking valuation discounts that result from the lack of control and lack of marketability attributable to a minority share. A qualified appraisal is required to determine the amount of the discount.

Dynasty trustA dynasty trust is designed to benefit multiple generations. It can include flexibility to allow the trustees to make distributions unequally to the beneficiaries, including those in low tax brackets, for their reasonable support, maintenance, education, and medical care. The donor may choose to set up a separate dynasty trust for each child and his or her family.

Grantor retained annuity trust (GRAT)A GRAT allows the grantor to transfer assets into trust and take back a fixed annuity for a specified term. The gift is valued based on the value of the assets transferred to the trust less the present value of the retained annuity payments. When the annuity term expires, the annuity payments cease and the property in the trust is distributed free of estate and gift tax to the beneficiaries, usually younger family members, either outright or in trust. This technique works best for appreciating property, and carries the risk that the grantor might die during the annuity term, in which case some or all of the value of the remaining assets will be included in the grantor's estate and may be subject to estate taxes.

Qualified Personal Residence Trust (QPRT)The QPRT is another technique that allows the grantor to place appreciating property (in this case, the personal residence or second home) into trust for a specified term, allowing the home to pass to the beneficiaries free of tax at the end of the term. The value of the gift is calculated by deducting the present value of the grantor's retained use of the home from the fair market value at the date of gift. If the grantor outlives the trust, he can remain in the home by renting it back from the beneficiaries, thereby further reducing his estate by paying rent to family members. However, if he dies during the term of the trust, the house will be included in his estate at its current value and be subject to estate tax.

Beware of Unanticipated ConsequencesThere are several unknowns that may come to play in the future, which makes the outcome of this type of gift planning uncertain. For one, the $5,000,000 lifetime exemption is set to expire at the end of 2012 and revert to $1,000,000. If you make a gift using the full exemption now, how will the excess $4,000,000 be treated for decedents dying after 2013? There is a possibility that the IRS could "claw back" the excess amount into the estate and tax it at current rates. Or it is possible that Congress will extend the $5,000,000 exemption to future years.

Less favorable outcomes will occur when gifts are made to trusts that have specified terms that the client does not outlive, or when the assets that are gifted do not appreciate in value. Consider the QPRTs that were set up and valued in 2007 with homes that have now lost 30% of their value.

Other ConsiderationsShifting a highly appreciating asset to the next generation by making a gift now to avoid paying tax on the higher value at the time of death can be a smart tax decision. Be sure, however, to run the numbers to determine if the tax benefits outweigh the cost of the transaction, and make sure your clients are aware of any potential pitfalls.

And, of course, gifts are irrevocable, so be sure clients don't give away assets they might need later in life.

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.